Most Economists Understand Neither The Cause of Nor The Solution To The Financial Crisis

As many writers have tried to point out, mainstream economists understand neither the cause of nor the solution to the financial crisis.

As an article this week in the Boston Globe notes:

Many [economists] frankly admit that they are not sure how to prevent things from getting worse.***

“Everyone that I know in economics, and particularly in the worlds of academic finance and academic macroeconomics, is going back to the drawing board,” said David Laibson, a Harvard economist. “There are very, very, very few economists who can be proud.”

A few suggest, as well, that there are deeper problems in the discipline. U.S. economists are asking aloud whether the field has grown too specialized, too abstract and too divorced from the way real-world economies actually function. They argue that many models used to predict the dynamics of financial markets or national economies have been scrubbed clean, in the interest of theoretical elegance, of the inevitable erraticism of human behavior.

As a result, the analytical tools of the trade offer little help in a crisis and have little to say about the sort of collapses that led to this one.

“You can’t just say, ‘I have a model for tremors that works great – I just can’t explain earthquakes,”‘ said Kenneth Rogoff, an economist at Harvard who has studied financial crises.***

The models used by macroeconomists do a poor job of describing the messiness of an actual market in flux.

As a result, economists end up oversimplifying such situations when they model them – or simply avoid studying them at all.

“We have a very restrictive set of language and tools, and we tend to work on the problems that are easily addressed with those tools,” said Jeremy Stein, a financial economist at Harvard. “Sometimes that means we focus on silly questions and ignore greater ones.”

Derivatives is a prime example of what economists totally missed.

The mathematical models predicted that the entire financial system would be stabilized by derivatives. But the models did not account for anything going wrong like – oh, I don’t know – home prices going down, hedge fund asset values declining, or currency or interest rate relations substantially changing.

Will Obama straighten things out?

Well, as the above-quoted Boston Globe article notes:

For years, leading economic figures like Lawrence Summers and Alan Greenspan argued that the United States had more or less brought the business cycle to heel.

Summers is a key Obama economic advisor.

And most of Obama’s advisors have profited handsomely from derivatives and other toxic investments. So they are not likely to challenge the status quo.

Unfortunately, economists – no less than lawyers, scientists, and just about every other class of professionals in the U.S. – have sold their soul to the powers-that-be.

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